Photo by Luke Sharrett/Bloomberg—Getty Images
By Phil Wahba
July 15, 2014

You’d think Lorillard (LO) shareholders would be thrilled with getting $27.4 billion from Reynolds American (RAI) in the cigarette mega-merger finally announced after months of speculation.

But Lorillard shares took a dive Tuesday morning, suggesting investors feel the many assets the company brings to the soon-to-be-created cigarette behemoth, from its head start in the e-cigs business to its hugely popular Newport menthol cigarettes brand, have not been fully appreciated by Reynolds, and that they could balk at the deal under its current terms. (Boards of both companies have approved the deal, which analysts say should be approved by the U.S. Federal Trade Commission within a year.)

Lorillard, the No. 3 tobacco player, owns the Newport brand, the best selling U.S. cigarettes with menthol, a mint-flavored additive, that has made them popular with African-Americans and young smokers. Lorillard gets the bulk of its sales from the Newport brand. (Menthol cigarette sales have been declining, though at a much slower pace than cigarettes overall. The number of traditional cigarettes sold in the United States has fallen 29.6% since 2004, according to Euromonitor International data. Adult smoking rates have fallen from 43% of Americans in 1965 to the current 18%.) And one wrinkle could come from regulators—the FDA has indicated it may put restrictions on menthol.

Lorillard also owns the market leading blu e-cigarette brand, giving it a strong position in a market now estimated to now be a $1.5 billion market, and set to grow 24.2% per year through 2018, according to projections from Research and Markets. To many observers’ surprise, the blu brand will be sold off to Imperial Tobacco as part of a big divestiture aimed at appeasing regulators but that will also bring in $4.7 billion to the combined company’s coffers. Still, the blu brand is an asset that helped Reynolds command that big pile of cash from Imperial. (Reynolds American will instead play its bet on the e-cigs market by pushing its VUSE digital vapor cigarettes, which it introduced last year in Colorado and is now rolling out nationwide.)

Reynolds said it expects cost savings of $800 million a year from the merger, via a reduction in overhead at the combined company, with the deal expected to contribute to its financial results as soon as the first year, and going into overdrive after that. What’s more, Lorillard has traditionally been strong on the East Coast and Reynolds on the West.

Reynolds is paying Lorillard investors $50.50 in cash for each share plus 0.2909 Reynolds shares, which including debt, comes to $27.4 billion, or $68.88 based on last night’s closing prices.

“We were surprised that the price paid for Lorillard was only $68.88, as we believe it is worth at least $72/share. Further, cost savings are larger than we anticipated,” said Wells Fargo analyst Bonnie Herzog.

Another benefit to the cigarette makers: the deal will combine the second- and third-largest U.S. tobacco companies and create a stronger competitor for Altria (MO), which commands about half of the traditional U.S. cigarettes market thanks to that company’s dominant Marlboro brand, by creating a massive No. 2 player.

According to a Wells Fargo survey of convenience stores, that could lead to bigger margins for cigarette makers (and ergo, smaller ones for retailers) and continue to shift more of the pricing power to Big Tobacco. Some 50% of retailers and wholesalers that service convenience stores surveyed recently by Wells Fargo said manufacturers have more pricing power than a year ago, compared to 30% saying that earlier this year. And this comes at a time dollar stores like Dollar General (DG) and Family Dollar Stores (FDO) are becoming major sellers of cigarettes, and traffic is declining at convenience stores, the biggest channel for cigarette sales. (CVS Caremark (CVS) will stop selling tobacco products this spring, a move that could ease some of the pressure on these retailers.)

As part of the deal, Reynolds American agreed to sell off several assets to the U.K.’s Imperial Tobacco Plc. In addition to blu eCigs, those brands include KOOL, Salem, Winston and Maverick. Imperial is acquiring those assets for $7.1 billion in cash, and Reynolds American said it expects to receive net cash proceeds of about $4.4 billion after taxes. B.A.T., which owns 42% of Reynolds, will continue to share technology with the combined company for the development and commercialization of new tobacco products such as vapor products.

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